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'One and Done' or 'More to Come'?

02 November 2017

'One and Done' or 'More to Come'?

The Bank of England has today raised interest rates from 0.25% to 0.5%. This decision to raise interest rates for the first time in more than 10 years has broken the interest rate calm that has existed in the UK for some eight years since the global financial crisis. It is undoubtedly hugely significant, for it represents the end for this period of ultra-low interest rates.

Investors searching for guidance as to where we go from here should look to the US. At the end of 2015, after seven years of rock bottom interest rates, the Federal Reserve did likewise when it raised the top-end of its target range from 0.25% to 0.5%. It didn’t stop there. The US central bank went on to hike interest rates three more times and, indeed, its latest message to the markets is that it intends to keep going until rates reach a level just shy of 3% (from 1.25% currently).

Is the Bank of England now following in the footsteps of the Fed? The short answer to this question is yes, after a fashion. There are more UK rate hikes to come, but they will likely be delivered gradually, for a number of reasons - which means perhaps only one more hike in 2018.

First, the rise in UK inflation pressure generated by sterling’s sharp fall since last year’s Brexit referendum is a temporary phenomenon and should subside over the coming year.

Second, although we expect sterling to struggle against Brexit uncertainty in the short-term, we do expect some light to appear at the end of the tunnel during the second half of 2018 as the UK moves closer to an agreement with the EU. Any recovery in the value of sterling based on a revival in optimism about Brexit should have the reverse effect in dampening inflation pressure.

Third, notwithstanding the recent rise in UK inflation, we continue to believe that we remain in what is a fundamentally low inflation global economic environment. This lessens upward pressure on interest rates not just in the UK, but globally.

And fourth, we expect the Bank of England to err on the side of caution in raising interest rates as the UK goes through a potentially substantial economic adjustment related to Brexit.

We characterise this upward trajectory in UK interest rates as a gradual normalisation, moving in tandem with the strengthening global economy - the Bank of England, in effect, leaning into the winds of economic growth.

This has important implications for the equity market. For the extent to which it is economic growth, rather than inflation worries that drive interest rates higher, this should not prove damaging for the equity market overall. This certainly seems to have been the case in the US. Despite the series of interest rate increases announced by the Fed over the past year, the US stock market has continued to chart all-time highs.

Some equity sectors will likely fare better than others in a rising interest rate environment. We are increasingly cautious about the outlook for fixed income investments and some of the traditional larger steady dividend paying stocks which have similarities with this asset class also appear vulnerable. These include many telecoms, healthcare and utilities stocks which have typically done well as interest rates have moved lower. That said, the robustness of the global economic environment should offer significant support to some of the quality globally- exposed industrials stocks. On the upside, a growth-supported, gently rising interest rate environment presents a supportive backdrop for financials – both banks and wealth managers.

It remains important to have an allocation to fixed income investments for portfolio diversification benefits which have been shown to improve risk return characteristics of portfolios over time and also to provide some downside protection. But investors should nevertheless be concerned about over-exposure to longer-dated bonds.

All told, today’s interest decision by the Bank of England signals an important change to the investment outlook in the UK. While in no way is this as dramatic or sudden as that visited on the UK economy by last year’s Brexit referendum, it is highly significant nonetheless. Investors will need to be alert to opportunities and risks as they unfold in this new slowly rising interest rate environment we now seem to be entering.

For further information please contact your usual Brown Shipley adviser.

Don Smith

Chief Investment Officer

 


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